A Closer Look at Earnings Expectations

In the aftermath of Friday's employment report, we posted an item on earnings expectations, passing along a chart from Societe Generale's James Montier that showed the lagging nature of equity analysts' earnings projections. At key turning points higher and lower, analysts tend to be led by earnings reports, not the other way around.

Which leads us to this item in today's Journal, in which Tom Lauricella wonders whether projections for the third and fourth quarter of 2008 might be a bit lofty. As the adjacent chart indicates, projections for the fourth quarter of 2008 have risen since January. The expectation being, at least in part, that the fiscal and monetary caffeine unleashed by the federal government will then be flying through the economy's bloodstream.

In the short run, all that stimulus will matter. There's no way--or reason--to deny that. But we expect the underlying fundamentals of the economy to remain extremely challenging. Here are a couple relevant excerpts from Lauricella:

First-quarter earnings-per-share are on track to post a 15% decline from a year earlier, according to Thomson Reuters. Yet analysts still expect earnings to be up 10% for the full year. That translates into a slight loss in the second quarter, solid earnings growth in the third quarter and a fourth quarter that would be the most profitable in history.

Thomas Lee, equity strategist at J.P. Morgan Chase & Co., thinks expectations for the fourth quarter are too high. The consensus forecast of roughly $93 a share for the Standard & Poor's 500 stock index as a whole would amount to "unprecedented profitability," he says. Meanwhile, the only two sectors that have posted record profits are energy and materials, which combined contribute just one quarter of all the profits from companies in the S&P 500.

Brian Belski, U.S. sector strategist at Merrill Lynch, says Wall Street stock analysts have a track record of being overly bullish about earnings rebounds amid economic downturns (and too bearish when earnings fall.)

Following the periods of declining earnings in 1991 and 2001, results four quarters after the trough of the downturn came in 50% below what had been expected when the economy was bottoming out, Mr. Belski notes. He expects that pattern to hold true this time around.

...

Stock-market strategists at Goldman Sachs Group Inc., who have been arguing that earnings expectations have been too high, said they were surprised that more companies aren't lowering earnings outlooks.

"It is hard to imagine that the current economic landscape was entirely incorporated in prior guidance," they wrote last week. "A more cynical interpretation is management will be the last to know when the proverbial 'other shoe' drops."

Related: Vitaliy Katsenelson's piece in Saturday's Financial Times. Katsenelson argues that the key to the "e" in "p/e" is profit margins, which are at or near historic highs. And ohbytheway, profit margins tend to be very serious mean-reverters. Here's Katsenelson:

Many people describe the stock market as cheap. After all, at 18 times earnings, p/e's are half of what they were eight years ago (those bubbly valuations are not coming back anytime soon) and only three points above their long-term average of 15. However, the "e" is temporarily inflated by all-time high (pre-tax) profit margins, which are at 11.5 per cent, or about 35 per cent higher than their multi-decade average of 8.5 per cent.

Historically, every time profit margins have become overextended, they have reverted towards the mean (that is, declined). This is because capitalism works. One company's excess profits are another's potential opportunity -– increased competition puts pressure on profit margins.

This time round is no different. If profit margins fell and stopped when they reached the average level -- an aggressive assumption as historically they have overshot and gone lower –- the market's p/e would rise from 18 to 22.

This is important stuff. As always, these cautionary notes do not constitute short-term forecasts of market direction. In the short run, animal spirits drive things higher and lower with only a loose connection to the underlying fundamentals. In the longer run, mean reversion remains a fact of life in the capital markets, and investors would be well-served to recognize as much.

The reality of mean reversion in profit margins might not precipitate big changes in investment strategy; indeed, for those who are appropriately invested, it shouldn't. But it should lead to relatively modest expectations for the coming months and years. And grounding one's expectations in a pragmatic sense of what's possible (and likely) will help keep short-term emotions out of the mix.

Comments

[drmalaka]

Fantastic article. Profit margins should also decrease because of rising commodity prices. Many companies are seeing higher input costs but can not pass on those price changes into this economy.

This is a rather scary short term market. It feels just like October of last year when we had that run and the market took all news as positive. However, in the end it is hard to believe we are not going to have a protracted economic slowdown.